Risky Small-Cap Funds Look Good ... for Now

Few investing phenomena have been as consistent as the tendency for quality small caps—thought of as those with positive earnings, less debt, and lower volatility—to outperform the broader small-cap universe. Indeed, the quality-focused S&P SmallCap 600 Index has trounced the more common Russell 2000 Index since its 1995 inception. But recently, this trend has reversed in a historic way. The Russell 2000 is on track to accomplish a new feat: beating its counterpart for a third consecutive calendar year. Over the trailing three-year period ended Sept. 30, 2025, the Russell 2000 outpaced the S&P 600 by a margin only seen during the dot-com bubble and 2020’s soaring market—two periods that subsequently saw violent reversals.

Small-cap funds vary in their volatility and aggressiveness, and those that crank up the risk are putting up better results than usual. That might make it tempting to jump on board now, but history suggests that it may not be wise. The following three funds with strong recent results get flagged for pursuing higher-risk stocks.

Franklin Small Cap Growth FSGRX, which carries Average People and Process Pillar ratings, isn’t afraid to buy the stocks of loss-making companies or those that miss earnings estimates or offer weak guidance in their quarterly reports, making it somewhat unique in the small-growth arena. The portfolio typically looks relatively risky because of a higher stake in volatile micro-caps than its average rival, as well as weaker historical average returns on invested capital and earnings. The fund performed quite well from 2017 through 2020 but took a step back during the choppy markets of 2021 and 2022. And despite a difficult year-to-date stretch, it still ranked in the top third of its small-growth Morningstar Category over the trailing three-year period ended Sept. 30. In addition to being streaky, a pending lead manager change is another reason to think twice about investing here.

Royce Small-Cap Opportunity ROFIX earns an Above Average Process rating thanks to a proven but volatile contrarian approach that has produced boom-and-bust performance. The fund has enjoyed success as markets rallied from 2023 onward, ranking in the top quartile of its small-value category over the trailing one- and three-year periods ended Sept. 30. The approach favors companies in the middle of turnarounds or earnings disappointments that look cheap relative to their assets or projected growth. It also isn’t afraid to invest in volatile micro-caps if the team sees value. The June 30 portfolio stands out for its roughly 70% weighting in micro-caps and lower profitability metrics than many of its category peers. A bottom-decile result in 2022’s bear market came not long after 2020’s top-decile performance, suggesting today’s sanguine market may not be the best buy signal.

Ariel Fund ARGFX receives Average People and Process ratings and has been quite a roller coaster since the global financial crisis of 2008. The fund’s managers readily accept higher volatility in exchange for better long-term returns, often anchoring to companies with higher debt loads and more-cyclical businesses. While years at the bottom of the category, such as 2022, highlight the pain inflicted when investors run toward safer assets, stellar results in 2024 and the first nine months of 2025 show the benefits. The investor share class ranked in the top quartile of the small-value category over the trailing three-year period ended Sept. 30.

This article first appeared in the October 2025 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting this website.